Schork Oil Outlook: Perfect Storm for Gas Bulls

In a seasonal context last week’s EIA reported delivery is huge. But, of greater concern is the fact that this is the second straight report which the market consensus flubbed. Last Thursday the consensus missed the actual report by 2.4 Bcf/d and yesterday the consensus missed by 4.3 Bcf/d.

Apropos last week’s report, The Schork Reportasserted that such an event was derived by “… either a mistake by the EIA or the beginning of a fundamental shift that the storage models have yet to indentify. If it is the former, then we will undoubtedly see a true-up in next week’s report.”

The biggest tell from yesterday’s report was that 75 Bcf delivery reported in the Producing Area. That is the third largest draw on record. An 89 Bcf draw in January 2008 and a 93 Bcf delivery in January 1997 are the only reports when the Gulf has seen a draw greater than last weeks.

In this light, it is clear to us that storage models have to be recalibrated, i.e. the impact of the 15-month purge in vertical rigs is indeed having a much greater than previously assumed impact on the supply curve.

As our friend Alan Lammey, markets analyst with Energy Intelligence noted, this event was undoubtedly masked by the dearth of industrial demand in the first half of this year and then compounded by a lack of gas-fired demand over the summer.

For example, through the first half of this year U.S. steel mill capacity averaged around 35% and chemical plant capacity was just below 70%. Meanwhile, cooling demand last summer was strong in ERCOT, but it was virtually nonexistent in every other market area (see illustration in today’s issue of The Schork Report).

Therefore, as late as August the EIA was still reporting (EIA-914 Survey) month-on-month gains in domestic gas production in the Lower 48. The surge in nonconventional (shale) production was assumed to be offsetting the purge in vertical rig counts (the basic proxy assumption for conventional production). In 2008 Baker Hughes reported that vertical rigs accounted for 51% and horizontal rigs (the proxy assumption for nonconventional production) made up 29% of the count. This year, as of last Friday, vertical rigs accounted for only 40%, while horizontal rigs surged to 41% of the count.

Bottom line, we think is it reasonable to make the argument that high, short-lived yields (followed by steep declines) from nonconventional production were responsible for the string of bearish EIA-914 updates through August.

But, so too was the lack of demand. To wit, as of October steel mill capacity was back up to 63% and chemical plant capacity was up to 75%. Furthermore, per the EIA’s latest updates (914-survey and Natural Gas Monthly or NGM), gross gas production in the lower 48 U.S. states decreased by 2.2% in September to an eleven month low of 61.83 Bcf/d. The EIA noted that Louisiana reported the only increase in production as drilling in the Haynesville shale continued, but all other areas reported decreases because of a combination of natural gas plant maintenance, repairs, and shut-ins due to low gas prices. Meantime, marketed production in the lower 48 dropped by 2.2% to a year-to-date low of 58.19 Bcf/d. The 3.4 Bcf/d of supply that has gone missing over the last two EIA reports (actual vs. consensus) is a potential tell that the lack of demand up through September was greater than previously thought.

The extant blast of heating demand is now pushing the demand curve to the right. Meanwhile, the industry has been making a strong effort over the last 15 months to shift the supply curve to the left, but the lack of demand hid this event.

Will it last? There is one caveat for the bulls to consider, there is a material amount of spare capacity in the form of deferred production. Estimates vary, but industry sources are in agreement that there is a significant number of nonconventional wells that have been drilled this year but not completed, either because of a lack of takeaway capacity or because operators are simply waiting for an opportunistic rally, such as the one we are currently in, to bring non-completed wells on-line.

Therefore, the $64 question is… at what price will operators be induced to frac these wells?